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Marcella Chow

Those closely following the global economy over the past year would have noticed a significant divergence in monetary policy between Japan and the rest of the world.
While the US Federal Reserve and European Central Bank have increased interest rates aggressively to rein in inflation, the Bank of Japan has maintained a loose monetary policy, keeping short-term rates negative and long-term rates around zero.
To stimulate economic growth and move Japan’s economy out of deflation, the BOJ has been deploying a negative interest rate policy and controlling the yield curve for government bonds since early 2016.
With negative short-term interest rates, commercial banks are charged for holding excess reserves with the BOJ. This, in turn, encourages commercial banks to lend more money to consumers and business, thereby boosting spending and economic activity.
Meanwhile, yield curve control targets the longer-term interest rates of a specific maturity of bond. In Japan’s case, the central bank has been buying and selling the 10-year government bond to maintain it at the target rate. Keeping the rate on long-dated bonds low helps to reduce the cost of long-term borrowing while encouraging investment into longer-term projects.
After loosening its yield curve control band from a long-held 0.1 per cent to 0.5 per cent last December, the BOJ decided to tweak it further last week.
From allowing long-term interest rates to move within a band of plus or minus 0.5 per cent, it now offers more flexibility – for long-term interest rates to move up to 1 per cent. Many observers have interpreted this as the first step towards monetary tightening for Japan’s central bank.

In many ways, the BOJ move makes sense. Japan’s consumer price index for June came in at above 3 per cent for both headline and core inflation – remaining solidly above the BOJ’s 2 per cent target. Japan’s spring wage negotiations also saw the biggest increase in wages since the early 1990s.
Furthermore, inflation expectations have been moving upwards over the past few months. At first glance, these macroeconomic indicators seem to satisfy the conditions for the BOJ to start tightening monetary policy. In reality, the path to tightening will not be straightforward.


The BOJ will have to navigate factors such as the potential repercussions of a spike in Japanese bond yields, the currency implications and the unwinding of its incredibly inflated balance sheet.
For now, the risks of a negative market reaction from a sudden spike in bond yields seem limited. The markets appear reluctant to challenge the BoJ’s intention of keeping 10-year government bond yields below 1 per cent.
Scenarios of banking-sector stress, like the collapse of Silicon Valley Bank in the United States, are unlikely as banks in Japan have a much higher and more diversified deposit base, even at a regional level, compared with the US. Also, unrealised losses on the BoJ’s bond holdings will not be an issue since government bonds are typically held to maturity.


While foreign exchange intervention does not fall within the BoJ’s jurisdiction – it is the responsibility of the finance ministry – the central bank will want to ensure there are no drastic fluctuations in the yen.
Should bond yields rise too quickly, it may lead to a sudden appreciation of the yen, particularly as US and European rates have already reached or are very close to their respective peaks.
The real predicament lies in the size of the BoJ’s balance sheet. Government securities have expanded by about 4.7 times on the BOJ balance sheet over the 10 years of quantitative and qualitative easing under former central bank governor Haruhiko Kuroda to top 580 trillion yen (US$4 trillion), equivalent to 102 per cent of the Japan’s gross domestic product.
The size of this balance sheet may prevent the BOJ from raising short-term interest rates, since positive rates would see the central bank having to start paying interest on current account reserves.
If short-term rates are raised without a significant reduction in the BOJ balance sheet, this may lead to the BOJ going into deficit. This would reduce the amount of revenue transferred to the government, putting it in a difficult fiscal position.
Pressure is building for Japan to give up ultra-loose monetary policy
While the details of how the BOJ will guide the Japanese bond market are still unclear, the BOJ will want to gradually trim its bond buying and balance sheet through quantitative tightening, before allowing short-term rates to rise.
The BOJ will be prudent in exiting its ultra-easy monetary policy, ensuring inflation and wage growth are concrete enough to warrant tightening. Japan’s central bank has only just scratched the surface of its tightening journey, and there remains much to be done.
Marcella Chow is a global market strategist at J.P. Morgan Asset Management


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Japan

The Bank of Japan has barely scratched the surface of monetary tightening

Morning commuters head away from Tokyo train station in Japan on March 30. Photo: Bloomberg

The Bank of Japan’s head office in Tokyo, seen on July 3. Many assume the central bank has embarked on a path of monetary tightening. Photo: Kyodo

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The front of an office building is seen in New York City on July 7. In New York, the value of grade A buildings rose 3 per cent between 2020 and 2022, compared with an 8 per cent decline for grade B offices. Photo: Reuters 

The Bank of Japan head office in Tokyo on July 3. The Japanese central bank’s decision to raise the cap on Japan’s 10-year bond yield has sparked speculation that more unwinding of decades of ultra-loose monetary policy could be in store. Photo: Kyodo

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Opinion

Business

After decades of easy money, the tightening journey will not be straightforward – or rushed
Rising bond yields and yen implications aside, the biggest challenge is in unwinding the massive balance sheet


After decades of easy money, the tightening journey will not be straightforward – or rushed. Rising bond yields and yen implications aside, the biggest challenge is in unwinding the massive balance sheet.


Central banks

Global monetary policy

Interest rates

Bonds

Banking & finance

Currencies

Macroscope

5050

Expresses the views, ideas and conclusions of the author. (Eg. Enough of Crazy Rich Asians, think of crazy poor Hongkongers.)
